Table of Contents
Financial management is an important aspect for any company that intends to make better returns on the investments. With increasing business opportunities, many companies may use various measures to enable them to expand into new markets to tap in an identified market. However, the financial implications, involved in such huge investments as expanding in totally new environment and new markets, can be taunting even to a medium sized company. In this case, it is important that company management evaluates the available sources of finance, both internally and externally to be able to tap in the identified markets. The financial resources, thus, are important and vital areas that need to be carefully considered, as they can open the potential for newer opportunities and investments. In trying to manage their financial resources, companies may opt for various financial practices, including issuing of bond and dealing in dual currency bonds, which will anchor their services in the financial markets. In the case of RJR, the dual currency bonds were instrumental in boosting the capitalization of the bond markets in American and Swiss markets.
It is examined that macroeconomic factors on dual currency bonds can cause the volatility of bond markets around the world since 1970s. While identifying the coupon interest rates on dual currency bonds, a number of variables are considered as major indicators. The strong correlation between the dual currency bonds and bond markets in the world are disclosed by various existing bond markets in the US and Europe. The developed and emerging bond markets provide a good illustration of dual currency bonds. It is deliberated that, on the valuation process, the economic and industry environment as well as the investigation of individual companies or stocks should be taken under consideration. In this study, involving the RJR, it is notable that the success or failure of dual currency bonds could be affected by the existing conditions between the domestic and foreign currencies, sociological, and economic factors. The economic and industry environment of a borrower and issuer should be considered during the purchasing of a dual currency bond by both parties, or, in other words, in the valuation of securities. Consequently, the significance of the economic and industry environment on the valuation process, distinguished by the top-down (the three-step) approach, contrasts with the bottom-up approach.
Dual Currency Bonds
A dual currency bond is a straight fixed-rate bond, which is issued in one of the currency, and pays coupon interest in that same currency. At maturity, the principal is repaid in the second currency. Coupon interest is frequently at a higher rate than comparably straight fixed-rate bonds. The amount of the dollar principal repayment at maturity is set at inception. Frequently, the amount allows for some appreciation in the exchange rate of the stronger currency. From the investor’s perspective, a dual currency bond includes a long-term forward contract. The dual currency bond is a system where a company’s local currency is denominated, and the interest is paid in that currency. However, the paid interest is redeemable in a different foreign currency. In case of the RJR, the dual currency bonds were low interest bonds, which were bought in foreign currencies, such as Swiss Franc and the Japanese yen but were redeemable through the US dollar. The coupons are usually set above the prevailing yields in the foreign currency, which are below the rates of the dollar bonds. The dual currency bonds depend on the appreciation of the foreign currency, determined by the foreign currency denomination, which is normally divided by the dollar redemption amount (Brown, 2010).
Similarly, dual currency bonds may be described as debt securities, upon which coupon interests are paid, using a different foreign currency, rather than the one in which the bond is issued. For examples, an investor may decide to buy a Eurobond using the dollar, which will pay interest in the US, and vice versa. An important element in dual currency bonds is the rate of exchange of currencies, which are normally identified in the bond price. There exist a number of types of dual currency bonds. One may scrutinize the reverse dual currency bonds, the traditional dual currency bonds, and the power reverse dual currency bonds. Each of them offers certain benefits, such as specifying the exact exchange rates, which are going to be applicable in the conversion of a currency into the other. It, thus, provides a lot of information to the investors to guide whether to invest in the dual currency or not. In other words, certain types of dual currency bonds empower the investor with prior information, which is important in making viable and sound business decisions. The dual currency bonds in the RJR industry were floated in the United States and in Swiss market in 1982. It was preceded by a slow but a steady issuance of Swiss francs against US dollar dual currency bonds over the next couple of years (Reilly, 2011).
The foundation, on which dual currency bonds are built, lies in the payment of coupon in the interests in the domestic currency of the borrower. This normally changes to reverse upon the maturity of the dual currency bonds. This is the time, when coupon interest rates are normally higher than the comparably fixed rates, prevailing at the market at the present time. The amount to be paid as the coupon interest on the dual currency bonds, usually as the dollar principle, is always agreed at the time of purchasing of the dual currency bonds. It is important that this amount is appreciated in the way the stronger currency avoids fluctuations in the final amount interest rate, payable to the issuer or borrower. The investor is normally conversant with the fact that dual currency bonds are long term contracts, which are not likely to mature in foreseeable future. They are normally issued between 10 and 15 years. This means that both the borrower and the issuer of the dual currency bonds might wait for a longer period of time for them to realize the coupon interest rates.
Furthermore, this implies that both the investor and the issuer of the dual currency bonds might be susceptible to the changes in the exchange rates between the different currencies, involved in the dual currency bonds. A common feature in the dual currency bonds markets is that they are attractive to large international corporations, which seek to expand their operations to other countries or regions. Traditionally, the coupon payment of the bond is made by the parent company, seeking to expand its operations on behalf of the subsidiary that is going to run the operations in the new country or region. Upon maturity, the multinational corporation, then, would expect the subsidiary to settle the coupon payment on behalf from the profits it gets from the operations. During these operations, it is possible for the parent company to suffer loss due to differences in exchange rates during the offer time, and when the coupon is repaid. This can occur mostly in cases, where the subsidiary is unable to repay the coupon interest, taken on its behalf. Thus, the payoff currency has been tremendously appreciated with respect to the currency, in which the coupon was issued. However, both the parent company and the subsidiary are susceptible to the risk of changing exchange rates in the dual currency bond deal, and thus, either of them will suffer adversely, when the exchange rates are unfavorable (Stafford, 2010).
Dual currency bonds are initiated by a borrower, who wants to raise funds through the issuance of bonds. It can be achieved by means of an investor, who contacts other investors and request them to act as lead managers in underwriting the syndicate to allow the borrower to enter a given bond market. The mandate to invite other investors in forming a group is, thus, given to the lead manger that negotiates contract conditions with the borrower of the bond in relation to the existing conditions on the bond markets in domestic and foreign markets. Furthermore, the group also acts as the overall manger of the bond that is issued to the borrower, acting as the underwriter of the issuance at the same time. An important step in the process of implementing a dual currency bond involves the raising of an identified amount of capital, which can be issued at a discounted price to the borrower. In this case, the group, consisting of the lead manager and other partners, form a selling group, which has the overall mandate of selling the bond to the borrower at a discounted price, through public offer. This is done upon the conditions that each member in the selling group has accepted getting an agreed percentage of the issue size. Also, the type of activities and the number of functions that each member in the selling groups attends are considered to be a determining factor in the final portion that each member in the selling group is entitled to. It is normal for the lead manager, who appoints the other members, to receive the largest portion amongst the selling group members, while the other members receive percentage, congruent to their contribution in the activities of the group (Reilly, 2011).
An important element in the execution of a dual currency bond is the ability of the borrower to compare all the costs of the modified foreign versus domestic currency, allowing in the cost of other related deals. It is also equally important to consider the pending notes, which are, yet, to be released in the domestic debt market. This helps to avoid a situation, where the borrower accepts a dual currency offer at a time, when the exchange rate is below the expected value from the issuer’s side. It avoids overpricing of the bond value, since the exchange rates between the domestic and foreign currency is, thus, exaggerated by the offloading of extra volumes in the debt market. In cases, where the debt market is offloaded, a wise decision is the investment restricting to the offshore market by using a foreign currency of another country, where the borrower has business as the domestic currency. This is done as a precautionary measure against unrealistic hedging. A prescription for such action would enclose issuing a five year bond that provide a benchmarking spread over the existing treasury securities in the local bond market, which can be used as comparables for various financial alternatives, being considered by the borrower. The percentage treasury securities could also be a good benchmark in making decision concerning the dual currency bonds as depicted in the RJR business plans (Stafford, 2010).
One of the essentials of success for large multinational companies in the current business environment is the ability to plan and forecast into the future. A dual currency bond is one of those ways of planning and ensuring that future business deals are taken care of. Through dual currency bonds, both the borrower and the issuer are almost certain of the amount they expect to get, say, in ten years time from their investments. In this case, they are better placed in making sound financial decisions and plans, which may impact accurately on the balance sheet of both the investor and the borrower. In other words, dual currency bonds are dependable investment tools that an investor, looking for long term investment, could rely on because risks can be foreseen and avoided and, thus, giving the investor power to control his investments.
Additionally, dual currency bonds are advantageous in a way because they help both the investor and the borrower to hedge and, thus, arrange the deal, so that it might allow the investment to pay off, when a separate deal would actually lead to losses or have a negative impact on both parties. The reason is that, in actual fact, dual currency bonds rely on the movement of exchange rates between the currencies involved in the deal, and is closed to other outside factors, such as stock prices and market variations, which normally affect standard investment deals. In practice, dual currency bonds reduce the risks that both the investor and the borrower of the bond are exposed to, and allow them to have deals that involve large sums of money, and therefore, expand their access to better terms of doing business (Stafford, 2010).
Types of Dual Currency Bonds
There are three current types of dual currency bonds on the bond markets. These are traditional dual currency bonds, power reverse dual currency bonds, and finally, reverse dual currency bonds. Each of them presents the investor and the borrower with a number of opportunities and challenges in the bond market. The traditional dual currency bond, for instance is able to specify the interest that could be payable to the investor in both the domestic current and principal amount of the bond as denominated in the bond issuer’s domestic currency. This is profitable to the investor and the issuer, especially when there is a considerable discrepancy in the currently existing interest rates between the investor and the issuer’s domestic currencies. The reverse dual currency bonds, on the other hand, exclusively pay the interest rates in the issuer’s domestic currency, thus disadvantaging the borrower in a way. This may be offset through the requirement that the principal amount may be denominated by means of the investor’s domestic currency (Reilly, 2011).
The major importance of reverse dual currency bonds is that they are essential in circumstances, where the interest rates requires both the issuer and the investor of the dual currency bonds to get profit in a single currency. This also can limit the potential of manipulating bond interest rates, and thus, limit the inside trading by both the investor and the issuer of the dual currency bonds. Finally, the power reverse dual currency bonds pay interest rates in the different denomination from the principal currency. The disadvantage is that this adds an element of risk because of the inherent potential of shifting of the coupon interest rates between the two currencies, which can be detrimental to the issuer and the investor. In addition, power reverse dual currency bonds can lock the interest rates at a given threshold, while other elements, inherent in the bond, can allow the issuer to cancel the bond at will. This may definitely affect the investor, especially where the issuer has the discretion to cancel the bond without notifying the investor. The three types can be applied concurrently or independently, depending on the agreements that the investor and the issuer of the dual currency bonds have, before they start trading (Reilly, 2011).
Apart from the different types of dual currency bonds identified, dual currency bonds also exist in variant forms, including the foreign interest payment security and the adjustable long term security with put option. These forms present the borrower and the investor with different entry options in the bond market, which allow them to analyze the prevailing conditions on the market before deciding to purchase a bond in a foreign currency. The dollar is hedged against the yen as the denominating currency, which allows the borrower and the trader to trade using the two currencies only. This is irrespective of the differences and fluctuations in the exchange rates in the currencies. Another variant is the special drawing right bond, which gives the investor an opportunity to set special conditions in the bond purchasing. The conditions are generally based on the specific conditions existing on the market, and the financial conditions of the borrower. The special drawing right bond allows the borrower to withdraw from the dual currency bond, and the conditions prove to adversely affect the performance of the company (Reilly, 2011).
The hypothetical valuation models illustrate the link between bond prices and macroeconomic variables. These include such models as Dividend Discount Model (DDM), Free Cash Flow Valuation, and Residual Income Valuation Model. As illustrated in these models, the current prices of an equity share are approximately equal to the present value of all future cash flows. Therefore, if any economic variable affects cash flows and required rate of return, it, in turn, influences the share value as well. As observed in the figures, presented in the case study of RJR business ventures, the general level of bond prices has been much higher at the top of a boom than at the bottom of a recession in the US during the period the company decided to have a dual currency bond in Japan. The figures indicate that characteristically, the turn in bond market prices occurs prior to the turn in business activity. Consequently, the evidence, presented in the exhibits, reveals that there is weak indication of the fact that macroeconomic volatility could help the company to predict market bond volatility, especially in the Japanese bond market. In the meantime, the available evidence is somewhat strong, and financial asset volatility helps to predict future macroeconomic volatility in the bond markets. This is both in the US and in Japan, where yen linked bond of the preferred variant of dual currency bond. Hence, bond market values are stated to lead the swing in the business cycle, and bond price indices are "leading indicators." This means that bond prices have already started to decline at the peak of the business cycle, while at the bottom of the business cycle they have already started to rise (Thorn, 1997).
Rationally for and Suitability of Dual Currency Bonds Purchased by RJR in Eurobond
According to the top-down approach, it is certified that the total returns for individual bonds are expressively affected by both the economy and industry. This is regardless of the assets that a borrower holds. On the other hand, the bottom-up approach opposes that statement, as it clarifies the possibility to find greater returns on bonds purchased, regardless of the economy and industry outlook. However, the top-down investment process has been strengthened by the outcomes of various speculative researches, examining the effects of economic variables on dual currency bonds. In addition to the individual quality and prospective profitability of a firm, it is also believed that the economical atmosphere and industry performance is influenced by the value of a security, and its rate of return. Therein, certain macroeconomic variables would be considered as indicators of risk that is common with most borrowers. Hence, the RJR investment in the dual currency bond against the yen could have been subjected to a number of factors, needed to be verified by the investment team before purchasing the bond (Stafford, 2010).
The suitability of the proposed financial tools for RJR depends on a number of factors, which exist in Eurobond and in the US. These factors include the political risk analysis, the prevailing income and economic structure of the company, the anticipated economic growth in the US and in Japan, the general ability of the company to meet its debt obligations, the continent and offshore liabilities, and monetary flexibility of the company. Other determining factors of the suitability of the dual currency bond proposal for the company are external liquidity, where RJR is in good conditions, as well as the public sector external debt in both countries together with the private sector debt burden. As such, the proposed financial tools are dependent on a myriad of factors, which should be analyzed by the RJR management and investment team to ensure that the best entry strategy is implemented. In particular, considerations of the ratings on foreign currency to be exchanged is important in the sense that it represents the ceiling for ratings, which are assigned to an obligation for a company, wishing to participate in the dual currency investment (Fabozzi, 2008).
Considering the investment in dual currency bonds, the RJR team needs to evaluate the existing Eurobond conditions to ensure that the right provision is utilized in the dual currency bond. The chosen investment bank that RJR is going to use should accept the floating rate loans as issued through Eurobonds. It must, however, correspond to the needs of the company in bond markets. For instance, it could accept the FRNs, which provide the flexibility of Eurobond, and which could give it the variable rates. This may allow for correspondence between the coupon rates, paid by the leading manager bank and the received interest rates from advanced loans. An illustration is viewed, where the leading manager, in this case the bank, wants to make frequent term loans, which would be indexed to LIBOR on a three month basis, thus allowing the company to source for funds between the indexed period of three months.
In the case of RJR investment in the dual currency bonds, it is envisaged that the bonds would take a period of ten years to mature at a rate of 10.125 percent of the initial value of investment on the dollar and 6.375 percent on the yen. The yen/dollar dual currency bonds, thus, amount to 7.750 percent annually, for a period of ten years. The bonds, due in 1995, were sold at 50% percent of face value. In the proposal, the DM value is 1000 par value, and thus, their yield to maturity in a period of ten years will amount as follows:
(DM1, 000, 000/DM500)1/10 - 1 = .07177 or 7.177% per annum
However, the maturity period for the bonds can be extended to 15 years, a period within which the bonds will be paid on the coupon interest of 7.750 percent. The bonds, due in 2000, were sold at 33.333 percent. They have a 15 year maturity. Their yield-to-maturity is: (DM1, 000/DM333.33)1/15 - 1 =.07599 or 7.599% per annum.
The three possible financing alternatives for RJR are Five year Eurodollar bond, Five year Euroyen bond, and Five year yen-dollar dual currency bond. Each of these financing alternatives presents the investment management with challenges in meeting the expressed value of annual coupon interest rate of 7.177 percent. The current liability structure of RJR allows it to hold a five year dual currency bond, since the exchange rate with the Japanese yen is favorable and also the foreign country’s economic stability is certain. There are no perceived economic and political challenges in the US markets and Japan markets, which would adversely affect the security of a dual currency bond, undertaken by the company. More important thing in the investment is the protection that the company has in terms of Eurobonds, which are offloaded annually in the European markets. This would let the company enjoy the protection of a strong and vibrant market in the domestic market, and also in the foreign market.
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It is indisputable that the dual currency bonds require the exchange of SF1, 000 of face value to be hedged at a value of 100 million dollars, as indicated in the investment plan. Therefore, the expressed rate of exchange, envisaged in the dual currency bond, which the company intends to offload to the Euro bond market, would be denominated by the amount offloaded, which would introduce the situation of the investor against the borrower in the Euro market. A computation of the proposed investment figures reveals that RJR would be prosperous, if it considered the increasing of amount allocated to the face value in order to increase the annual percentage point that is expects from the dual currency bonds. Moreover, the dollar is expected to depreciate against the yen as the Japanese economy grows a pace greater than the US economic. This is a situation that is likely to bring a difference in the exchange rates between the currencies of the two countries.